The various global financial downturns experienced in the past have underlined the relevance of engaging in effective risk management to enhance the sustainability of different industries. The banking sector is one of the industries faced with numerous risks that could undermine the performance of the financial institutions considerably. As such, there is continued emphasis for the banking players to engage in risk management practices in their daily operations for the sake of creating long-term value as well as being in line with the current regulations on threat mitigation (O’Kelly 69).
Importantly, the latest entrants in the banking industry need to consider the various risks associated with aspects such as the fluctuation of currency prices, credit, interest, liquidity, operations, market, and reputation to bolster their survival in the new environment (Kanchu and Kumar 147). In this regard, Bank A, which seeks to extend its operations beyond Mainland China by establishing a branch in Hong Kong, requires considering and understanding the various types of risks they could encounter in the new environment. Therefore, this paper provides advice to Mr. Chen, the chief executive of Bank A, regarding the various types of risks the bank could face while operating in Hong Kong as well as the ways of managing some of the threats.
The Major Types of Risks Faced by Banks in their Daily Operations
There are several types of risks encountered by banks. The common threats concern the elements of the market, credit, liquidity, operations, and reputation. Bank A is likely to experience most of these risks, and thus understanding them is crucial before integrating the fundamental threat management approaches in its daily operations.
The banking market subjects the players in the industry to an array of risks. Interest rate risks, currency risks, and price risks influence the marker in the banking sector. The risks constitute the external forces that affect the performance of a bank either positively or negatively.
Interest Rate Risk
The dynamic nature of the interest rates in the banking market could have an adverse impact on a bank. Essentially, the time differences in maturity, as well as changes in prices of liabilities, assets, and off-balance sheet commitments, have significant effects. A financial institution needs to manage its interest risks by monitoring the repricing gap of the bank’s liabilities and assets carefully (O’Kelly 124). The strategy is crucial for safeguarding the bank’s interest, and thus operating profitably. Besides the repricing factor, the basis risk is another source of interest rate risk that could influence the operations of Bank A. The basis risk emanates from the variance in the differences in the interest rates gained and paid on various financial instruments bearing similar repricing attributes (Kanchu and Kumar 149).
The currency risk emanates from the continually changing foreign exchange rates. Some daily engagements that could expose a bank to currency risks include commercial banking operations, foreign exchange deals, and the currency structure (Hull 106). Therefore, Bank A needs to manage its currency risks within acceptable limits to avert the adversities of money fluctuations. The strength of the currency used to handle the liabilities and assets of the bank is crucial for minimizing the associated risks resulting from foreign exchange variations. Therefore, it is advisable for Bank A to denominate its assets and liabilities in United States dollars and Hong Kong dollars among other stable currencies. The foreign exchange market has a considerable influence on the operations of a bank that serves various customers. Therefore, it is necessary for risk managers to regularly take note of the foreign currency trends (Christoffersen 129).
The price risk affects the capital and earning of a bank significantly as a result of alterations in the prices of securities. The different prices of securities such as equities, bonds, and commodities influence the level of earning as well as the capital possessed by an operational bank (Kanchu and Kumar 146). For instance, changes in the price of stocks triggering equity risk could expose Bank A to potential losses that can lead to the failure of the new entrant into the Honk Kong financial market. Further, the dynamic aspect of commodity prices owing to the current demand and supply patterns also poses a risk to the profitability of a banking sector player. The prices adopted for different transactions and open positions for facilitating the daily operations of a financial institution have a considerable influence on profitability.
The credit risk arises from the failure of a bank borrower or counterparty to settle the payment of a credit facility as per the agreements with the bank (O’Kelly 98). The defaulters usually expose the bank to financial constraints that undermine the efficiency of their operations. The uncertainty entailed in the repayment of the credit offerings and the time aspects of repaying the dues expose the bank to credit risk. It is important to note that all banks in the financial industry face credit risk in their daily operations, and Bank A is not an exception. Factors including business failure and income inadequacy influence borrowers to default credit agreement with a bank. Notably, credit risk affects the bank negatively by declining the value of credit assets besides lowering the attainable profits from credit transactions (Duffie and Singleton 34).
Liquidity risk exposes a bank to a situation where it fails to meet the costs of its day-to-day operations (Christoffersen140). Normally, a bank should have streamlined liquidity, which enables it to fulfill payment requirements from its primary operations as well as accumulate sufficient money to offer loans. The liquidity risk could predispose Bank A to a bank run where account holders might consider withdrawing their money from the bank, thereby escalating the financial position of the institution. In an adverse situation, a bank affected by the liquidity risk may be put under receivership where the government intervenes to protect it from total collapse. Therefore, Bank A needs to manage liquidity risk effectively to avoid tarnishing its image in the Hong Kong banking industry.
Operational risks refer to the loss experienced by a bank due to the inefficiencies of internal processes, human resources, and systems as well as external events (Christoffersen145). In most cases, human errors and mistakes trigger operational risks. Hence, it is imperative for professionals to be keen in observing the conventional processes required to execute different tasks. The human risk aspect of operational risks could either be triggered willingly or unconsciously. An example of an operational risk that Bank A might face in the Honk Kong environment is the erroneous filing of information when clearing checks. The leaking of confidential information is another example of an error that could expose the bank to operational risks. The adopted computer systems could also subject a bank to operational risks if such systems fail or undergo programming errors. Since contemporary banks consider the integration of technology systems as crucial, it is important for a bank to ensure that its systems work efficiently to minimize the occurrence of operational risks (Bushman and Williams 4).
Reputational risks arise from the engagement in activities that can damage a bank’s brand image, thereby affecting the earnings, capital, or liquidity of the financial institution negatively (Kanchu and Kumar 152). Failure to observe the values and beliefs of the bank may prompt it to engage in inappropriate undertakings that have the potential of tarnishing the image of its brand significantly. Further, unethical practices within the bank can damage the reputation of the institution, thus undermining its competitiveness in the industry. Other triggers of reputational risk include failure to comply with regulations, poor customer service, misleading rumors about the bank, and decisions taken by the bank in critical circumstances (Hull 114). In this light, Bank A should be aware that every action it takes is judged by the stakeholders including customers, investors, and opinion leaders.
The Management of Credit Risk and Operational Risk
An international bank needs to manage risks effectively to boost its competitiveness in the industry. Credit risk and business risk constitute the two most important risks that call for the adoption of practices, which undermine their occurrence. In the case of Bank A, efficient management of the credit and operational risks is crucial for bolstering profitable operations in Hong Kong.
Managing Credit Risk
The management of credit risk requires the establishment of a suitable environment that reduces the chances of a bank incurring losses after offering financial facilities to customers (Hull 120). In this case, the bank needs to know the customers before transacting with them as it is one of the key steps that facilitate the success of the credit process. Thus, the acquisition of pertinent, accurate, and timely information about the client is crucial for creating an environment that reduces the possibility of offering customers credit facilities blindly.
The bank needs to apply a streamlined credit-granting process. In this respect, it should analyze both the financial and non-financial risks before granting the customer a credit facility (Duffie and Singleton 35). The bank needs to use different strategies for identifying risk, which include identification, analysis, quantification, mitigation, monitoring, and anticipation. Doing this before granting the credit package to the consumer minimizes the associated risks.
The maintenance of a proper credit administration, measurement, and monitoring approach are also crucial for an international bank to effectively manage financial risks (Bushman and Williams 7). The credit management plan should consider aspects such as the projection of the individual or business performance in the future, the anticipation of challenges, matching the appropriate loan, agreement development, and securing the credit through collateral and guarantors (Duffie and Singleton 37). The measurement element should oblige a bank to price the deal in a way that the credit repayment would compensate the transaction adequately. Monitoring the relationship requires the financial institutions to assess the financial profile of the customer regularly.
The efficient management of credit risk necessitates the financial system to control a transaction. Controlling credit risk facilitates proper tracking of the threat, thus reducing the element of surprise (Hull 81). The provisions of the deal need to ensure that the bank has total control of the terms and conditions that secure the interest of both the financial institution and the borrower.
Managing Operational Risk
A financial institution needs to explain operational risk clearly to the staff to foster an understanding of the issue and how it impacts their performance (Bushman and Williams 12). Thus, a functional risk policy needs to be implemented across all the business lines in the financial institution. The approach is essential since it facilitates the identification of the causes of operational risk.
The creation of a culture that promotes operational risk awareness is necessary for a financial institution. A bank should conduct a regular review of the behaviors of the staff to reduce errors that might expose the organization to operational risks (Bushman and Williams 8). Constant communication of the acceptable code of conduct and working standards is also critical in eliminating operational risks in a bank.
The management should oversee the processes undertaken by the junior employees of a financial institution to ensure that they engage in practices, which are in line with the acceptable standards (Hull 77). The involvement of operation managers among other senior officials in supervising employees in a bank shows their commitment to ensuring that the right procedures are followed when providing different financial services to customers.
Financial institutions are exposed to an array of risks that require consideration and management to foster competitiveness. The main types of risks in the banking sector include credit risk, operational risk, market risk, liquidity risk, and reputational risk. The adoption of practices that identify and mitigate the risks is crucial for facilitating the efficient running of a financial institution.
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Christoffersen, Peter. Elements of Financial Risk Management. Academic Press, 2012.
Duffie, Darrell, and Kenneth Singleton. Credit Risk: Pricing, Measurement, and Management. Princeton University Press, 2012.
Hull, John. Risk Management and Financial Institutions, + Web Site. John Wiley & Sons, 2012.
Kanchu, Thirupathi, and Manoj Kumar. “Risk Management in Banking Sector – An Empirical Study.” International Journal of Marketing, Financial Services & Management Research, vol. 2, no. 2, 2013, pp. 145-153.
O’Kelly, Brian. Risk Management in Banking. John Wiley & Sons, 2015.